The economics behind that blockbuster deal

With everyone and their mothers weighing in on last weekend’s megadeal between the Dodgers and Red Sox, the general narrative has largely been written. The Sox are looking to revamp for 2013 by shedding payroll and any expensive acquisitions preventing the Epstein Era from giving way to the Cherington Era. The Dodgers are going for it all to capitalize on the momentum of replacing pariah Frank McCourt with L.A. hero Magic Johnson as the face of ownership. That apparently means giving Ned Colletti a blank check to make out to any underperforming teams with former All-Stars on the roster.

As Dave Cameron mentioned in his synopsis of the deal, the Dodgers are grossly overpaying for players because the feeling is that now is the pivotal moment for the franchise. The Dodgers’ performance in 2012 and 2013 could be the difference between charting the path to a long-term stranglehold on the massive L.A. market or watching as the Angels surpass them in popularity, revenue, and on-field success. Similar thinking was responsible for the Marlins’ and Angels’ spending sprees this offseason, with the financial implications of their strategies still unclear.

Analysts have offered myriad reasons why this season and next season will determine the fate of the Dodgers and various explanations for how this deal could affect each of these factors, but how much do we really know about what determines a team’s revenue? As Dave pointed out a few weeks ago, we actually don’t know a whole lot, and in the case of the Dodgers most of this speculation about the future is just that, speculation. That said, we can still analyze many of the determinants of revenue within the context of the Dodgers to better comprehend what happened this weekend.

Ownership change

One thing is clear about the Dodgers’ situation: Fans like the new ownership more than they liked Frank McCourt. I’m pretty sure fans liked rush hour traffic on I-5 more than they liked Frank McCourt and all of his controversies. What is not clear is just how significant the impact of new, likable, devoted ownership has been on fan interest and fans’ subsequent response to winning. Attendance is up significantly over last year, but the team is also much better and in the playoff hunt. It’s likely the attendance bump is an interaction of both factors, but it’s hard to say what attendance would be like with a winning team had McCourt stayed.

More importantly, with very few comparable situations in baseball, it is almost impossible to say what the effect of the ownership change will be on the revenue generated by winning in the next couple of seasons. In other words, we don’t know how much more valuable winning in 2012 and 2013 is in the long-term than winning in 2015 simply due to the momentum generated by the ownership change. This uncertainty is the primary reason that there is so much risk involved in the Dodgers’ plan. If the returns to winning are much, much greater right now than they will be in three years, then basically paying $260 million for Adrian Gonzalez is a little easier to swallow.

Playoff runs make money

This has been said a million times—most clearly by Vince Gennaro in his book Diamond Dollars and on his MLB Blog—and is true for a variety of reasons. In the Dodgers’ case the most important effect of a playoff run is that fans seem to be able to stomach a price hike in the following season. Again the important question is how important it is for that playoff run to happen now rather than a few years from now.

Winning increases revenue in big markets… or does it?

One of the preeminent theories of academics studying the returns to winning in baseball is that larger markets increase the revenue generated by winning. In my own research I find that in general this is the case, but the effect is relatively small and is counteracted in the L.A. market by the presence of many other pro sports teams (more on this to come).

There are two main reasons market size doesn’t necessarily imply that winning generates more revenue. The first is that each team’s relationship with its fans is unique, so general factors like market size have varying impacts and as a whole explain very little of the team variation in the returns to winning. As an example, the White Sox and Cubs play in the same market. The Cubs are a bad baseball team. They currently rank 10th in attendance. The White Sox are a very good baseball team. They currently rank 24th in attendance.

The second, and very important, factor is that stadiums have a natural capacity constraint. I believe this is the main reason that by my estimates teams such as the Dodgers, Yankees and Red Sox haven’t necessarily had the highest returns to winning in the last 15 years. It’s not that fans don’t care whether they win, it’s that there’s nowhere for the additional fans to sit because the teams are already selling out.

In the case of the Dodgers, interest was starting to wane during the end of McCourt’s reign and they haven’t been to the playoffs and won World Series as often as the Yankees and Red Sox, so there is certainly some room for growth. On the other hand, regardless of how many home runs Adrian Gonzalez hits, Dodger Stadium can hold onlyt 56,000 people, so it may not be possible for them to recoup their money, even in a perfect world.

Two letters: TV

For the Dodgers the capacity constraint matters. Enter television. Signing huge television deals allowed the Angels and Rangers to spend big on free agents and the Dodgers are essentially taking out credit on their looming new TV deal to be negotiated for the 2014 season. If the TV bubble bursts, then this gamble could fail miserably and a few years from now we could be talking about how this was one of the worst financial decisions in sports history. If it continues to grow, then winning now could pay for all of the Adrian Gonzalezes, Carl Crawfordes, Josh Becketts (and Nick Puntos?) a team could ever want in the form of TV cash.

There is no capacity constraint on television, and regardless of whether the Dodgers create a regional sports network or sign a long-term deal with a major broadcasting company, they will make a ton of money come 2014. The question is how much and, more importantly, how winning now will affect the deal. This is where the level of uncertainty grows. If the Dodgers had sat on their hands this year and rode out the season to a .500 record followed by a slightly better record and no playoff appearance next year, how differently would the TV negotiations go? The team would probably make less money, but your guess is as good as mine as to how much less.

Who owns Hollywood?

One reason cited for the Dodgers’ unfailing devotion to the here and now is that the Lakers’ high profile acquisitions of Steve Nash and Dwight Howard mean that the spotlight will quickly shift to the purple and gold this fall. If the Dodgers want to maintain interest beyond this year in a city that focuses on the latest trends, then they’d better capitalize on the publicity this summer.

My research finds that as the number of other pro sports teams in a market increases, the returns to winning decrease. Given that the NBA season doesn’t get going until after the World Series and L.A. doesn’t have a NFL team, for the Dodgers this effect would likely not be felt until next spring. The theory is that marginal sports fans who would attend Dodgers games only when the team is good are simply too preoccupied with playoff basketball, or even hockey, to show up until those seasons are over. Therefore, when the Dodgers win early in the season the expected bump in attendance and revenue never happens because the die-hard baseball fans show up regardless and the fans affected by the success are still at the Staples Center.

This general effect is estimated across teams, so whether it exists in L.A. is less certain, but it’s reasonable to assume it may have some impact. This is not an argument against trying to win; it just suggests that being in a market with lots of other sports teams does cut into the Dodgers’ business and likely cancels out most of the effect of having such a large market base to draw from. To the extent that they can keep publicity on themselves and away from the Lakers, this trade could not only increase wins, but also blunt the negative effect that the beginning and end of basketball season and other sports will have on revenue. Like most of the other factors considered, the magnitude of the effect in this specific case given the marquee deals made by L.A.’s two biggest sports teams is very uncertain.

Keeping up with the Angels

Counter to the effect of pro sports teams, having another major league team near you increases the returns to winning, implying that the looming Angels in Orange County make winning matter more for the Dodgers. This seems to make sense, though it doesn’t apply in all situations—as Dave Cameron correctly pointed out to me, Yankees fans probably won’t jump ship for the Mets if their records are reversed.

In L.A., it could be the case that some marginal fans go to a few games each year and might choose which team to go to based on who’s better. To the extent that not every person willing to pay for baseball in the L.A. area defines him or herself as a Dodgers or Angels fan, it could be important for the Dodgers to establish themselves as the best show in town. It seemed like a tall order after this offseason, but in true Hollywood form the Dodgers have found a way to steal the spotlight. The Angels certainly made a good payday in their offseason television contract negotiations by arguing that the Dodgers were down due to the McCourt debacle. There’s no telling how much the Dodgers would stand to make after 2013 if they can turn that argument around.

Marquee man

Adrian Gonzalez is the pinnacle of last weekend’s trade because of his projected on-field performance, but as Vince Gennaro has noted, superstar players have the ability to generate interest and team revenue simply through their presence on the team. This “marquee value” is likely amplified for a Mexican-American such as Gonzalez in the heavily Mexican market of L.A. The magnitude of this effect is difficult to quantify, but to the extent that the capacity constraint does not limit Gonzalez’s ability to generate real revenue, it could be significant.

Adding value to a $2 billion investment

If all of the aforementioned factors do align and the Dodgers make as much revenue as possible in the next few years thanks, in part, to this weekend’s trade, then they will likely recoup their massive investment and then some. That is a lot of ifs, though, and seems like wishful thinking. There is one more game-changing context in which to consider the Dodgers’ situation, however.

At some point the time will come when the new owners, dare I say, sell the team. Most people are still reeling from the $2 billion price tag paid earlier this year for the Dodgers and it’s really difficult to imagine a day when the team will be sold for an even higher price, but trust me, it will happen. While short-term revenue is the logical economic context in which to consider player personnel decisions, more than one team executive I have spoken with has pointed out that teams typically sell for two to two-and-a-half times revenue and that sale value is something which should not be overlooked.

From a baseball standpoint the Dodgers seem to be living in a world of unbounded optimism, hoping that the water in L.A. will turn aging underachievers into superstars once again. In some cases (Hanley Ramirez and Gonzalez) this may not be too much of a stretch in the near future, but in others (Beckett and Crawford) it’s hard to imagine a world where the production validates the money. These moves were not about efficient roster creation, though. They were a response to almost every conceivable determinant of revenue and team value indicating that now is the time when the Dodgers need to be relevant, financially viable, and competitive.

The problem is that we still do not know enough about the economics of baseball to say with great certainty whether the long-term difference in value between a Dodgers team with Gonzalez, Beckett, Crawford (and Punto?) and a Dodgers team without them is enough to validate the $260 million those players are owed, in addition to the players the Dodgers gave up. As Cameron wisely posited a few weeks ago, attendance is down just up the road in Anaheim after the biggest free agent signing in baseball and the emergence of the best player anyone’s seen since… ever?

In the present context it is hard to contemplate a Yankees franchise that does not lead the league in payroll, revenue and value. There was a time when the Yankees business model was an absolute failure, however, and George Steinbrenner believed in his heart of hearts that the best way to correct the problem was to pour money on it. Whether it was this approach or efficient roster creation leading to four World Series in five years that created the financial monster we are accustomed to today is up for debate.

Perhaps five years from now we will have an even better idea of what determines revenue for each specific team and by then will know whether last weekend’s deal helped create Yankees West or destroy the Magic Johnson era of Dodgers ownership before it began.

References & ResourcesNote: Apologies to Nick Punto. He’s actually one of my favorite players, but I can’t help but make light of how much enjoyment he seems to be getting from essentially being the player-to-be-named-later added on to this deal.

Comments

I think it is pretty clear what led to the Yankees four World Series: Steinbrenner’s suspension from baseball activities in the early 1990’s. That put the Yankees in the hands of their baseball people, and with the losing teams that they had, they acquired the players who made those four championships possible: Jeter, Posada, Pettitte, Riviera, among others.

The Yankees after that, with Steinbrenner spending more and more, shows the efficacy of trying to buy a championship when you have an aging, past their peak roster.

Unless there is an economic implosion similar to 2008 happening soon, the Dodgers should have a deal signed before year end, whether creating their own network or accepting a huge contract with an existing network.

Given the risks of what could happen, I would think that the owners would hedge their bets by signing a contract with a cable station to ensure a steady cash flow for a long time, rather than take on the risk of starting their own station, where they might make a lot more, but then take on the risks that you note here. With how much they paid for the team, plus the potential downsides, I think the conservative business decision would be to sign with a station and contract out to receive the steady (HUGE) flow of revenues, at least equal to what the Angels got ($150M per year). That will finance both their big payroll spending as well as justify the high price they paid for the team.

I think the question is whether any of Steinbrenner’s antics or spending in the years leading up had any effect on the fan response once the team started winning again. There was obviously a long Yankee tradition and huge fan base before Steinbrenner even took over. In those years when he spent big and they lost not too many people showed up, so it seems hard to make an argument that his approach had any effect; however, we don’t have the counterfactual of how irrelevant they may have been if they were bad AND had a less visible, tight-pocketed owner.

George’s money paved the way to those championships. What they developed down on the farm was simply not enough.

What got the Yankees into the post season in 1996 was realignment and playoff expansion. Otherwise, the Indians and Rangers would have been playing in the ALCS. And without Wade Boggs, they wouldn’t have even been there WITH realignment and playoff expansion.

What got them back to the World Series in 1998 (114-48) was free agency. David Cone and David Wells were a combined 38-11; the Yankees 49-11 overall in their starts. Replace with with a pair of .500 pitchers and Boston wins the East.

(Yeah, I know the Red Sox finished 22 games behind; but NYY were 5-1 against Boston in games that Cone or Wells started. So in addition to the Yankees record dropping to 95 wins, Boston picks up two to give them 94.

But excuse me! Tino Martinez (arrives 1996), Paul O’Neill (arrives 1994) and Chuck Knoblauch (arrives 1998) might not have been signed as free agents, but those trades were essentially salary dumps by small market clubs who couldn’t afford to re-sign them – and shipped them off to the Big Apple. And don’t forget Tim Raines and Darryl Strawberry, signed that preceding winter and providing 29 homeruns and 104 RBIs)

It might have been baseball people running it after he was reinstated in 1993 – but just as in 1977-78-81, it was George’s $$$ that made the difference between a 2nd or 3rd place finish with a decent team and a pennant.

I think the point that’s missed in analysing this deal from the Dodgers point of view is that the increase in TV funds available to all clubs means that the marginal cost of a win is likely to increase substantially. If the often quoted $5 million/win was to change to $6, 7 or 8 million per win, then the deal starts to look much better for the Dodgers, in the same way that Gonzalez’s contract already looks pretty good compared to other elite first basemen.

Obviously, having more money to spend made a big difference for the Yankees but if you look at who they brought in, it’s fair to say that Steinbrenner’s absence also helped. None of the free agents/trades that the Yankees made in those years were really big names, other than, perhaps, David Cone. Guys like O’Neill, Martinez, Scott Brosius, were solid players but not the high profile types such as Reggie Jackson and Dave Winfield that George liked to sign. I think it’s fair to say that George’s money was important-they couldn’t have brought in those players without the large payroll-but that his absence allowed the baseball people to build a team rather than simply collect players.

I see now why everyone started calling the Dodgers, the ‘Yankees of the West’. Afterall, the Yanks spent over 2 billion trying to win another WS, and the Dodgers have now started down that road. I wonder how long it is before the herd starts in on ‘we shoulda done it sooner’ and the olde “we’ll get them next year”.

On the other hand, this move made a lot of people watch the last weeks of Dodger play, wondering if the events of 2007 might happen yet again….